c1 cost down to $13 wmt, page-58

From Australian
At first glance the Fortescue Metals result appears to defy credulity. A day after BHP Billiton’s iron ore division reported a 54 per cent decline in earnings, Fortescue, with a higher-cost, lower quality and more leveraged business, held its earnings decline to only 3.6 per cent in the December half.



There is an explanation for the apparent financial gravity-defying performance which produces a more realistic appraisal of Fortescue’s performance, without detracting from the underlying impressiveness of what it is continuing to achieve in difficult industry circumstances.

While Fortescue reported only a slight fall in earnings, from $US331 million to $US319m, its reported result included $US200m of “finance income”.

That income is actually mainly attributable to a $US192m gain from the opportunistic and intelligent decision Fortescue made to buyback debt it has on issue that has been trading at a significant discount to its face value.

Given that the biggest threat to Fortescue’s stability in the context of the plunge in iron prices has always been its leverage and the $US8.4 billion gross debt ($US6.1bn net) that it carries, taking advantage of the substantial discounts to reduce the debt levels and the interest bill associated with it makes compelling sense. The full-year interest savings of $US1.1bn in early debt repayments in the half amounts to about $US88m.

Even if the impact of that “finance income” were backed out, however, at an earnings before interest and tax level, Fortescue held the decline in earnings to about 24 per cent against the backdrop of an iron price that was about 40 per cent lower than in the same half of the previous financial year.

That’s a real achievement driven by the quite extraordinary operating performance and improvements Nev Power and his team have been able to generate within Fortescue in response to that collapse in the price — two years ago the average iron price for the corresponding period was 170 per cent higher.

A year ago Fortescue’s “C1” costs were $US30 a tonne and its “all-in” costs close to $US50 a tonne. In the latest half-year, its C1 costs were about $US16 a tonne, its delivered cost to China $US18 a tonne and its “break-even” price was $US28.80 a tonne. Moreover, its guidance is to exit the 2016 financial year with C1 costs of $US13 a tonne.

The $US1.4bn by which the group has lowered its cost base from the same period a year ago has enabled it to almost entirely offset the impact ($US1.57bn) of the fall in the iron ore price, with volume gains and lower royalty payments helping only at the margin.

While a significant decline in strip ratios (the amount of dirt Fortescue has to remove to get to the ore) has been a material contributor to its cost performance, and a source of some cynicism about their sustainability in the market, the group has improved almost every aspect of its operations with an emphasis on lowering costs and generating cash.

It has also taken every opportunity to push out the repayment timetable for its borrowings, with the first repayment -- $US4.8bn of senior debt and $US577m of unsecured notes — not scheduled until 2019. In the meantime, it would hope to generate sufficient cash, and take advantage of opportunities to buy back its debt at discounts, to manage the repayment and/or refinancing task.

Whether it is its confidence that it will be able to continue to drive costs down and generate sufficient cash to manage its debt commitment or a desire to thumb its nose at its far larger competitors, BHP and Rio Tinto, Fortescue maintained its interim dividend at US3 cents a share, fully franked.

Its directors said they were confident in the company’s ability to generate operating margins and cash flows to meet or exceed the capital debt repayment obligations. Both Rio and BHP, of course, have announced radical changes to their dividend policies that will lead to a dramatic reduction in payouts.

With the iron ore price recently firming to around the $US50 a tonne level, the early months of its second half are generating very similar revenue to that achieved off the back of the average price of ore in the December half.

Whether that’s a temporary blip or not is a matter of some debate, with a lot of analysts believing the price will fall back and potentially fall back significantly. In circumstances where both Rio and BHP appear to believe the odds favour the price being lower and staying lower for a long time, Fortescue’s drive to lower costs further is not only sensible but necessary.

It knows that, while it might target Rio and BHP and criticise them for their increases in production into a falling market recent years (even though Fortescue has added more tonnes to the market than both of them combined) there is a lot of new production that has just entered or is yet to enter the market over the next few years.

With China’s demand appearing to have peaked and looking fragile as its growth rate slows and the composition of growth changes rapidly, one wouldn’t be too optimistic about the medium term outlook for the price.

Fortescue, with still higher costs than its Pilbara rivals and lower quality ore (which means its ore is attracting a discount of up to 14 per cent against the index price) can’t, given its debt levels, be complacent. Each reporting period that passes with its confirmation of further significant reductions in its unit costs signals that it isn’t.